Time Running Out for Greece, Eurozone

The European Central Bank’s opposition to restructuring could push Greece over the edge sooner rather than later. But it won’t be the end of the euro, writes Axel Merk of Merk Investments.

Disagreements on how to address Greece's reform process boiled over last week when European Central Bank (ECB) President Jean-Claude Trichet walked out of a meeting. Trichet warned that if Greece were to extend the maturity of existing debt, the ECB would stop supporting Greece.

We have long argued that it is not in Greece's interest to default at this stage, because Greece needs to get its primary deficit under control before restricting its debt.

As further reforms are implemented, the risk/reward ratio for Greece will change to potentially favor a default to reduce its debt burden. Delaying default benefits Greece because any default now would impose an immediate adjustment of the primary deficit (and it may be impossible to get new loans at palatable terms).

However, if ECB deserts Greece, the risk/reward assessment for Greece changes. If the ECB gets too tough on Greece, dynamics in Greece may drive political dynamics to favor a default—or even a re-introduction of the drachma.

Mind you, this would not be in Greece's interest. A default now won't fix Greece's underlying structural issues. Leaving the Eurozone might cause an implosion of Greece's financial system. But from Greece's point of view, if they feel deserted by the ECB, political dynamics may favor the worst of the bad choices at hand.

As far as the banking system in the rest of the Eurozone is concerned, we know that central banks—including the ECB—are bad poker players. However, if the ECB indeed pushes Greece over the brink, they would provide ample support to the rest of the banking system. It would certainly expedite the process of raising more capital in the Eurozone banking system (some of it through national governments).

Earlier this month, Trichet said potential ECB losses in the wake of a Greek default were "not a problem."

Trichet emphasized that all countries must live up to their responsibilities—weak countries in implementing reform, and strong countries in offering support.

The euro initiated a sharp selloff as soon as Trichet started speaking, possibly because the ECB did not indicate another interest-rate hike was imminent. However, it should be noted that the ECB Governing Council is going to have eight new faces on its 23-member panel in the coming months, with a significant shift toward a more hawkish composition.

There will also be a new ECB President later this year, and he will have to prove his inflation-fighting credentials; a German tabloid recently embraced the most likely successor, the Italian Mario Draghi, by depicting him with a Prussian helmet.

Combined with inflation indicators that continue to tick up, it appears that more tightening is, in our assessment, quite likely. For now, however, the market appears to have embraced profit taking with regard to the euro.